The news has been full of stories of actual and suspected financial statement fraud at major public companies including Enron, WorldCom, Tyco, Global Crossing and Adelphia.
However, smaller, private companies are more likely to commit financial statement fraud than larger, public companies.
In many cases, that’s because:
* Smaller, private companies are often perpetually trying to raise money to fund current operations and expansion needs. This can put pressure on management to falsify financial statements to obtain a loan or investment capital.
* The financial statements of small companies are often unaudited, and those firms frequently have limited financial controls, giving management a freer hand to manipulate financial statements. Controls that do exist are often overridden.
There are often numerous signs of financial statement fraud, but they are ignored or overlooked. Among the red flags of financial statement fraud:
* No meaningful financial controls, including segregation of duties, management/board review and approval of transactions exceeding certain dollar thresholds; access controls to financial data maintained on the company’s computer system; and frequent review/reconciliation of key financial statement accounts.
* Deteriorating industry conditions and characteristics, such as significant competition, unfavorable economic conditions, regulatory changes and/or increased governmental oversight and industry practices that condone unethical behavior.
* Financial results that don’t make sense, including extremely high year-on-year growth rates; increasing revenue and profits when others in the industry are experiencing the opposite; increasing profits coupled with deteriorating cash flow; and overly aggressive financial targets and forecasts.
* Related-party transactions that lack economic substance.
* Frequent turnover in accounting firms, which may be a sign the company is not getting the opinion it wants, or that the firms are getting too close to the truth.
* Bonuses based solely on financial performance measures, which can place pressure on management to manipulate financial results to meet bonus targets.
* Inability to produce requested documentation, either because it doesn’t exist or because the production of such documentation would tip someone off to the fraud. David M. Duffus, CPA, is a consulting manager with Sisterson & Co. LLP. Reach him at (412) 594-7717.
